US Airlines are Competing Fiercely and Wall Street Doesn’t Like It

Airlines have been releasing their quarterly earnings reports over the last couple of weeks, and the results have been downright excellent. They’re all making money hand-over-fist, but not everyone is pleased. Wall Street, in fact, is not happy that the airlines are actually trying to compete with each other. That’s keeping fares lower, and that means some analysts think the airlines aren’t doing everything they can to maximize profits. I see things differently.

The airline that really sent shockwaves with its earnings call was American. In the second quarter of this year, American made $1.9 billion net of special items. That meant the airline earned a pre-tax margin of more than 17 percent. Holy crap. That’s starting to sound like a normal company.

But that wasn’t the news that spooked investors. During the quarter, American’s PRASM dropped 6.9 percent versus last year. PRASM stands for passenger revenue per available seat mile. To calculate PRASM, you take the number of seats on each airplane and multiply them by the number of miles they fly during the period (that gives you your ASMs). Then you take the passenger revenue (or, uh, PR) and divide it by the ASMs. The resulting PRASM is a metric that tells you how much money your flights are generating. So while American had record profits, it was because its costs dropped like a rock thanks to low oil prices. Revenues dropped as well, but not by nearly as much, so… record profit.

What is it that can cause PRASM to drop? Well, some of it is boring stuff, like currency exchange rates. But the real substance can be boiled down to two things. If fares are steady but fewer seats are filled, then PRASM drops. If the number of seats filled remains steady but fares drop, well, then PRASM goes down too. Those two metrics drive PRASM changes, and this last quarter, dropping fares appear to have been the biggest issue.

Some of this was due to specific macroeconomic issues. In Brazil, for example, the economy has gone to hell. It’s so bad that even after cutting capacity 20 percent, American’s PRASM was still down 24 percent as the airline had to drop fares to fill the seats it did fly. Yikes. But that’s not American’s fault and analysts aren’t suggesting it is. What analysts don’t like is that American is getting aggressively competitive in certain markets.

Dallas/Ft Worth is a perfect example of what’s going on here. It’s an enormously important hub for American and it’s under tremendous price pressure. Remember, last year the Wright Amendment went away and Southwest was suddenly allowed to fly anywhere in the US from Love Field. It has added a crazy amount of capacity and fares have responded as you’d expect… by going down. American isn’t immune to this even though DFW is not Love Field, so it has been staying competitive. At the same time, it has stepped up its game and is tracking Spirit much more closely than it did before. (US Airways has long operated this way, while American was more hands off.)

Why doesn’t Wall Street like this? In a research note from July 24 entitled “The Frustration Continues,” Helane Becker, analyst from Cowen and Company, had this to say.

The main takeaway we had from the AAL call was American stating they have become a price taker rather than a price setter. Given their size and product, we do not believe they should ever be a price taker. American has cited the competitive market in Dallas as a major reason for their PRASM woes, but this should not have been a surprise. There was always going to be an impact from the repeal of the Wright Amendment but we do not believe American should be a price taker. Southwest has repeatedly state that their Dallas load factors exceed 90%. Given Southwest aircraft are nearly full, American should be able to have a better mix of airfare on its aircraft. We believe American needs to concede some local market share to Southwest and just focus on what makes them potentially great.

In other words, American is big and important, so it should be able to focus on the corporate market and charge what it wants since low cost carriers are serving a different market. I just don’t see it that way.

This is why revenue management exists. If there is a competitive fare in the market, American should match it and then revenue manage its flights to determine how much to sell at that low fare. If American can fill its airplanes without taking that low fare, then great. But if it needs to take that low fare, then it should have that tool in its toolbox. Considering how much capacity entered the market last year, it’s no surprise that fares would drop. But American needs revenue management to manage this in the short term. In the long term….

American realizes that today’s low cost carrier is tomorrow’s behemoth. Remember when people said Southwest wasn’t a threat? Incredibly, it wasn’t that long ago. But look at Europe where Ryanair and easyJet, airlines which were supposed to be ignored because they targeted different types of travelers, are now making big inroads into the corporate market. You think a day won’t come where Spirit makes that same play? American is being smart by trying to compete now. The backdrop, of course, being that it is raking in a very respectable margin so it has the ability to invest in long-term fights that it wants to win.

For now, that means consumers are the winners because they get lower fares on multiple airlines. Might this eventually be proven to be the wrong strategy for this particular issue? Sure. But that’s not where I’d put my money.

I talked about this back in May when I said that higher fares meant airlines were just inviting competition. Will the numbers say that they could have charged more and cut capacity more? Sure, you can always cut capacity and increase fares. But that’s a short term strategy. In the long term, there’s a delicate balance. Just ignoring the competition isn’t going to make it go away.

I’d argue that some analysts probably aren’t really considering these long term ramifications appropriately. This isn’t about adding a crazy amount of excess capacity. It’s about properly managing markets that are already important. I like to see an airline that’s paying close attention to the competitive landscape and acting when there’s a threat. Is it maximizing its profit for the quarter? We don’t know for sure, but the profits this quarter are just fine, thank you. More importantly, the airline has to position itself for the long term future of the business.

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Sounds like “The Southwest Effect” is alive and well, at least in Dallas. Of course, LUV is being punished by the same “analysts.” The REAL problem is that the Big 4 CEOs are allowing Wall Street to dictate their moves. To wit: SWA announces modest growth (by their historical standards) of 7-8%. Clearly, they intend to do this by replacing timed-out 137/143 seat 737-300s with 175 seat 737-800s on a one-for-one basis, a conservative and financially correct decision. Immediately, LUV loses 30% of its value, driven by “analyst” critiques of “over-capacity.” So Southwest revises their growth estimate to the “lower end” of their estimate. And now, magically, LUV is beginning to regain some traction. Imagine that!……………This is one of your better posts. You excel in your “back-room” analyses and I hope you continue playing to your strengths, Mr. Cranky.

Arubaman – It’s not really the Southwest effect I don’t think. It’s just that there is a TON more capacity in the market then there used to be. Capacity goes up, fares have to come down. Southwest already served most of these markets one-stop before so there was some Southwest pricing in there already.

Nick – I don’t think so. I think Southwest had to go low to fill those seats, but with extremely high loads in Dallas, Southwest didn’t take long before it started pulling back on the rock bottom fares.

Jeremy – It’s funny because this came up in the earnings call. (It wasn’t SFO or SEA specifically but the whole concept.) Remember “Advantage Fares“? Those were the fares that DOJ was sure would disappear in the merger. Well they haven’t. They’ve expanded. So now you see American putting lower walkup fares in markets where it’s weaker as a way to take more traffic from the other guys. It worked well for US Airways and will likely do the same at the broader American.

That was a fantastic read and I enjoyed learning about PRASM and how it applies in this situation. As a business traveller, I’d like to add that the days of my flying Business Class are gone, even for long hauls. My company will only pay for the lowest economy fare now, which are non-upgradable even if we employees wanted to pay out of pocket for an upgrade. Spirit, Ryanair and EasyJet look like great options to my Finance department, who never actually travel for work.

I agree, if a ticket price is considered excessive it’s onto Spirit or WN or whomever can get me there cheapest. Flying is Business or F class is out of the question. The problem isn’t so much my employer but instead my clients that pay for the travel as “additional services” on our contracts. If I do a flight down to DFW and it’s $1500 for a flight they’ll question it. Worst case is we could lose a client over what they consider excessive travel costs. AA can’t rob me just because I fly for business or I’ll be forced onto the competition. Last I checked SY does fly into DFW.

It is not surprising that analysts are not pleased, but like you pointed out, there’s alot of reasons why that doesn’t make them right. No one is going back to the old way of marketshare wars for the hell of it. But airlines are trying to be competitive on price in a realistic way, because if they aren’t, they will see significant losses to LCC/ULCC competition, as well as seeing their international margins shrunk by competition to major hubs from foreign carriers. Part of Delta’s strategy of buying into airlines is a hedge against this problem, by controlling (albeit in a minority shareholder role) the flights into some of its hubs.

Don’t you think American is also still a special case because of merger integration? Even though they have gone very slow and haven’t had any big screw-ups, it has been painful to fly the airline(s) – and they have operated as 2 separate airlines with different upgrade policies, elite benefits, etc. And historically US had a weak product, and AA an old fleet, and the catering has been horrid. So it wouldn’t surprise me if quite a few flyers, especially business flyers, have been booking away from AA/US, hence revenue weakness.

The power and short term fixation of Wall Street analysts would be amusing if it didn’t have a direct financial effect on the airlines. Airlines aren’t catering to the 1%. Rather, they are selling a perishable commodity – an airline seat. Once the flight leaves the gate any unsold seats are permanently unsold. After a certain number of seats are sold, you’ve covered your costs and the remainder is almost all profit. So adjust the price to try and fill every last seat. What is the point of be the price setter if you don’t fill the seats and lose money on the flight? Am I missing something here that the analysts know?

Becker from Cowen thinks she runs the airlines. Consider that she probably was part of the reason for CEO change at JetBlue as well as the added bag fee at JetBlue. She called for more earnings.
The airlines need to run their business and ignore these Wall Street “managers”. The airline business is complicated. I doubt that any “outsider” truly knows the ins and outs of the airline business.
The SWA “effect” in Dallas is unique. American will just have to tough it out.

I might be repeating what has been said in prior comments, but this is where a strong airline CEO/leader and hopefully backed by the board of directors need to tell Wall Street “analysts” that they are a value stock not a growth stock. Value means that the assets, cash flow and business model has value/clarity and the overall benefit of the stock is that it will kick out a dividend if profits are made.

The only definition of growth stock to me is the breeding of a bad management mentality of “meet the week, meet the month and meet the quarter”. This causes poor planning, especially long term for any business, especially a fuel and employee dependent business like an airline. The problem overall with growth stocks is that it also breeds an investor mentality of just winning the lottery not creating a winning long term business.

I worked for a profitable industry that pushed itself on to Wall Street in the mid 90s as a growth stock with a completely unsustainable expectation of EBITDA (earnings before interest, taxes, depreciation and amortization) of 15% growth per year no matter the economic conditions. Remember this was a profitable company and putting it on the list of a growth stock was “sexier” than value. It became a bad situation and I moved on to privately held companies.

Ok….other than DFW area, SEA & FLL where are these ‘highly competitive markets’ that are diluting PRASM?
Two weeks ago we had the DOJ saber rattling over fare collusion. Even fractional markets like NYC, LA area and CHI land seem to have reached equilibrium between the Big 3 + 1 (with a few spoilers here & there).